Thursday, May 20, 2010

With the CPI having fallen a bit in April, and the equity market behaving as if a double-dip recession is in the cards, fingers are pointing to the very slow growth in M2 and warning of deflation and other dire consequences. Pundits can be mistaken, of course, so it's always best to do some homework. As of today's release, M2 growth, on an annualized basis, is 0.6% for the past 3 months, 0.5% for the past six months, 1.5% for the past year, and 5.1% for the past two years. The reason for the slow growth in the past year is that growth in the prior year was exceptionally fast, as should be clear from the first chart above.

For the past 15 years, M2 growth has averaged about 6% per year. Over the past two years it has only grown 5% on average, but it is still above what looks to be its long-term trend. For purposes of comparison, I note that since 1995 nominal GDP growth has averaged about 5% per year, and real GDP growth has been about 2.5% per year. Inflation has averaged about 2.5% as well, and has been relatively stable around that level. All of these are fairly unremarkable numbers, and about as stable, on average, as you could hope to see.

From these facts I conclude that there is no basis for the widespread concerns about the economy being starved for money, about deleveraging leading to a Japanese-style slump, or about deflation. As I've maintained all along, the strong growth in M2 in late 2008 was driven by a surge in money demand (and a big drop in money velocity), while the slow growth in the past year has been a sort of pay-back, with money demand declining and money velocity picking up.

On a final note, I see that the 3-month annualized growth rate of M2 has increased from a low of -1.4% four weeks ago, to 0.6% today. This, in the context of the level of M2 approaching its long-term trend, seems perfectly reasonable. The behavior of M2 going forward will tell the tale of whether we have too much money, or not enough. It will also be important to watch M2 velocity, since it has a long way to go to "pay back" its decline over the past year or so. If M2 velocity keeps rising and M2 growth also picks up, even modestly—which would not surprise me at all—we would have the essential ingredients for some monetary inflation.

50 comments:

The screaming headline on the WSJ (for those of you who still read paper newspapers) was "Lowest Inflation in 44 Years!" or something to that effect.

Asset values of all types are lower today than three to four years ago, and of course, stocks are lower today than in 1999.

Monetarism explains a lot, but sometimes it misleads.

And when people are scared or defeated, I see little ability for monetarism to get the cart rolling again. It can stand out of the way--that is, provide ample supply--but it cannot get behind the cart and push. On those rare occasions, that;s when some deficit spending is on order.

It is to bad we have been deficit-spending 2000-2007, and that we blew a couple trillion on Iraqistan. It limits our options now.

I don't like the idea of even more deficit spending now, but interest rates at zero may not be enough to stimulate.

Some inflation would be useful here, as interest rates at zero would translate in real negative interest rates--in other words, spend it, or invest it, or lose it.

Certainly I think we can rule out any "the Fed is too loose" arguments.

I disagree about your comments on deleveraging. I think the entire planet is trying to deleverage despite what economic books say should happen to capitalistic markets when for example, mortgage rates hit all-time lows.

People and institutions are rolling back like Walmart. Cash is king. So unless the vast money centers are going to spend all of that saved money, we have a long road ahead.

I think gold + commodities tell us money is in ample abundance and therein lies the problem. Central banks have been printing away for decades and maybe this time it's just not going to workout as planned.

alstry: No, I haven't. But comparing the two is like apples and oranges. An increase in debt outstanding does not necessarily require an increase in M2. Debt could double, for example, without any increase in M2. So what would be the point of the comparison? Most of the charts I've seen that do compare the two are terribly misleading, since over time debt growth has been much higher than M2 growth.

OT, but here's a pretty cool interactive program to try your handing at stabilizing the US debt situation. Didn't like all the choices(ex: I would cut the fed work force by more than 5%)but it is quite interesting.

There is no doubt that there is far too much debt in the world and the USA is as big a culprit as anyone. I wish I could claim credit for this but it is probably the most important thing I read today and it concerns the world's debt load. It goes something like this:

Most of the time it is a good idea not to let our imaginations run too far ahead of events. I don't know, you don't know, NOBODY knows, how the we will ultimately deal with the huge debt loads around the world. What we do know is, that for better or worse, the problems will be dealt with one step at a time, over a period of time, and NOT all at once. Investors should analayze and possibly act as information comes in, piece by piece, and avoid making sweeping, emotional, and/or sudden judgements on issues that could take many monthe, quarters, or even years to resolve.

Like I said: I sure wish I'da thunk that! Its not for everyone. But for some of you, maybe it will be helpful. I know it is for me.

Paul: I started playing with the choices for debt reduction but stopped as soon as I saw they were assuming that renewing the tax cuts would cost trillions. No supply sider would buy into the logic that not raising tax rates would reduce tax revenues by that much.

You make valid points for those who wish to opt out of the markets because of these worries. Vast numbers of people have done just that. It was not for these that I considered the post, but for those who recognize opportunity in panic, and great value in great companies securities that have been driven to bargain levels by fearful people. In my many years in the securities markets I have seen similar panics many times, and the worries are always dire and the consequences of bad decisions have always been fearful to contemplate. Yet our markets have always found investors willing to embrace the risk if the potential rewards are high enough. I have made the assumption, perhaps in error, that there are such people reading this blog. It was them I had in mind. The ideas are certainly not for everyone.

Agree with you, I'm nearly 50 (Your right I dont look it lol)How many of these ''Its the end of the World'' events have we lived through.

My first one was the Soviet invasion of Afganistan 1979..the gold price went up, many predictions of 10,000 USD an ounce, World war 3, we will all be living in caves etc etc.

The Latin American Defaults, The Asian Defaults, Russia,tech bubble, 9/11,Iraq WMD,Lehman etc etc....And we are all still here getting on with our lives!!

Sometimes its good to have a few years on the clock instead of being a twenty something day trader, if the price is right someone will buy it, all problems get solved or ignored...The World moves on...

travels: Re stagflation. I think you are basically right, but I also think that most economists would say that the UK is not quite yet in the grips of stagflation. Inflation would need to be at least 5% or more, and the economy would need to be generally listless for some time. UK growth has been pretty weak, so that qualifies, but inflation is not yet high enough, but nevertheless reasonably close.

Stagflation is bad, because it means there is too much money in the economy and investors spend their time speculating on prices rather than investing in growth-enhancing enterprises.

It was before I got into the securities business but I well remember our years of 'stagflation' in the 1970s. President Richard Nixon had closed the gold window signaling the end of the Bretton Woods monetary accords made during the waning months of WW2. Watergate had forced his resignation and Gerald Ford of Michigan was President. The Vietnam war was winding down and our economy was struggling with high unemployment (economic stagnation) and rising prices (inflation). The conundrum was labled 'stagflation'. The economic growth rate was not robust enough to significantly lower unemployment and an inflationary psychology dominated the capital markets. Many have blamed it on the many years of Vietnam war spending. Scott's economic history is probably more accurate than mine, but the period was characterized by chronic high unemployment and rising prices.

President Ford had a political campaign called 'WIN' for 'Whip Inflation Now'. The WIN program was a flop as I recall, so a choice had to be made to either stimulate the economy to bring unemployment down and feed the inflation fire, or raise interest rates to unprecedented levels to kill inflation psychology making the unemployment situation worse. The fear levels were extreme. Both choices seemed to offer economic destruction. The Nouriel Roubini of the day was a man named Dr. Henry Kaufman and he was in every newspaper and magazine spinning dire consequences no matter what was done. The markets were terrible. Everyone was pessimistic. Vast numbers of investors were in cash.

The Federal Reserve Chairman at the time was a man named Miller and his policies were not very dramatic. When President Jimmy Carter was elected in 1980 a man named Paul Volker became Fed Chairman, and he embraced the plan to kill inflation first and reboot the economy from a low inflation base. Short term interest rates went to something like 15% and the unemployment rate stayed quite high. However the high rates reduced the money supply and broke the inflationary psychology. As inflation and long term interest rates fell, the stock market began a bull market that lasted until late 1987. Prosperity was returned to America by a low inflationary economy that allowed interest rates to fall to levels not seen since the early 1960s.

This is my 'off the cuff' recollection of America's period of 'Stagflation' and how we escaped it. Every reference may not be precisely correct but I believe they are close.

Growth will probably remain elusive for some time, emergency budget is June 22 which means cuts and more cuts.

The UK economy is basically London, you mentioned too much money speculating, this always happens to London property every cycle, there have been plane loads of Chinese,American,Russian and Germans buying up comm real estate for the past 9 months.

Thanks for that, perhaps the new Gov have some tricks up their sleeve to avoid stagflation.

I remember the 70 as being pretty bad in the UK also, there was the oil shock as it was called when OPEC stopped selling oil to the West, UK ended up with a 3 day working week, sky high petrol prices for the little you could find, inflation went really high, no growth and every one on strike, happy days lol.

Then along came Thatcher in 79 and sorted the whole mess out quite quickly as I recall, cant remember how she did it though!!

Scott can explain it better than me but I believe she did it by what many today call 'supply side' economic policies. Basicly low inflationary monetary policy and less government spending. Right after Margaret Thatcher was elected in Britain, Ronald Reagan was elected in the United States. They held similar economic beliefs.

Scott,

Are you familiar with something called the OECD Composit Leading Indicator? I believe it is a rather comprehensive gauge of business activity in the many countries that make up the organization. It supposedly forshadowed the '07 - '09 recession, but is currently said to be rising at the fastest rate in 20 years. I went to the OECD website but can't find a link to that indicator...it may be proprietary.

The Reagan/Thatcher formula for success was tight money to provide support for the currency and bring inflation down, plus lower tax rates to boost entrepreneurial activity, plus deregulation to shrink the size and influence of government It worked in spades and was copied by many other countries. That's exactly what we need now.

I'm not familiar with the OECD indicator but will look it up if I have a chance. Family activity is keeping me busy this weekend.

Your both right, I remember now, a few weeks after the election our pay packets became heavier through big tax cuts and I think company/business taxes were cut also.

On the flip side gov spending was massively cut back through firing gov workers. A lot of the utility companies were made leaner then sold off, the privatisations were all very successful, except the railways.

The social unrest though was far worse than what you've seen in Greece on your TV, gov employees in easy jobs and people used to sitting at home on generous welfare were very, very unhappy....Dont know if the new UK gov has got the stomach to go through all that again!!

Is there any good book/author/theory on "inflection points"? I am wondering if it is possible to "extract" this phenomena and describe its basic ingredients. It could go from different areas of knowledge, but maybe it could be applied generally to any kind of events.

I do think the European crisis calls for further easing of US monetary policy. The fall in the dollar has been the main driving force behind inflation this past year. Now that the dollar is rising, the fed needs to resume purchases of long-term debt and keep the federal funds rate at 0% for the next 6 months at least.

On the fiscal side we need a true stimulus package. This would require a reversal of almost every Obama domestic policy initiative, deregulation, cuts in marginal tax rates and a plan to shrink the structural deficit by bringing entitlement spending under control.

I have located the OECD leading indicators information I asked you about. The US and European components show continuing expansion while China and Brazil show a leveling off. Since the latter economies have been so hot, a slowdown would likely be a good thing.

If you are interested, go to the OECD website and under the 'Statistics Directorate' menu click on 'leading indicator and tendency surveys'.

Please take a look on three BRIC ETF:FXI, EWZ, RSX - looks like buyers emerged, (even one permabear I follow became short/medium term positive after this sellof). EURUSD works as a EU Confidence Indicator now and neither ECB nor FED want hem to see as falling off the cliff undermining the sentiment, so bounce/stabilization is likely.But further gradual weakening is possible. The time will tell, though.

US monetary policy is already quite accomodative and fiscal policy is as aggressive as I have ever seen it. While there are those who maintain none of this matters, and we are all on a train about to crash, the economic numbers just do not paint that picture. If you go back over Scott's many posts you will find ample evidence of this.

As I see it, either Milton Friedman was correct in his assertions that inflation 'is always and everywhere a monetary phenomenon' or he was wrong and monetary stimulus by central banks does not matter under certain conditions. I am in Professor Friedman's camp. I believe monetary stimulus from central banks work and the current worries over sovereign debt, while problematic, are manageable given proper central bank and political policies. Everything I have seen points to these issues being addressed by the appropriate authorities. With the US and European economies in either recovery or outright expansion I see little need for the Federal Reserve to further be more accomodative when short term rates are already near zero.

Panics in financial markets occur from time to time. We are in another one that to me is an 'aftershock' of the Lehman Bros bankruptcy and mortgage crisis. IMO this one, while serious, is not nearly in the same league. In any case, the issue is an European one, and while our Fed should be supportive of the ECB, as I believe they have, I do not think any further action is warranted.

I agree with you. The Euro had an up week last week vs the USD. The US equity market had what looked to me like a climactic (for now) selloff and bounced up sharply at the close friday. I am expecting a pretty sharp rally near term.

The panic has been fairly pervasive lately and the markets will need time to settle down. I think there will be a fair amount of back and forth action over the next few weeks, but maybe (X fingers) we have seen the worst for awhile.

"Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy."

and

"After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die."

I think I see your point: Low interest rates is indicative of tight money. I think money can be tight due to commercial bank policies but CENTRAL bank policy is in my view accomodative if money is practicly given to commercial banks. I still think Prof Friedman believed the reserve increases provided by Central banks would work their way into the economy through increased commercial bank lending and thus be expansionary.

John,I think the reason why bank reserves have failed to enter the economy this time is interest on excess reserves. This policy was implemented for the first time in Federal Reserve history on October 6th 2008. Banks can earn 0.25% APR by holding cash as excess reserves. This is more than they can earn at somewhat greater risk on 1, 3 or 6 month T-Bills. Consequently excess reserves went up over 500 fold between September and December of 2008. They now stand at over one trillion dollars.

The huge expansion in the monetary base is consequently meaningless. Interest on excess reserves is a deflationary policy that is beginning to take its toll on the economy.

.25% APR on excess reserves is certainly more than nothing but not much more. It is tight commercial bank lending policies that keep the money there. As qualified borrowers emerge there is still plenty of incentive for banks to lend.

Maybe that is an important factor but I have trouble seeing .25% as a meaningful deterrant if a good loan to a qualified borrower is available. I still think it is fearful emotions and balance sheet worries that keep banks from making loans. The economic shock was greater this time so it is reasonable to assume the recovery time will be longer. As long as the incentives are there lenders and borrowers will get back together in greater numbers.

Benji: You seem to have forgotten that Reagan had to incur debt to defeat the Soviet Union. His great success at this provided subsequent Presidents with a peace dividend thereby allowing them to spend less on the military.

This worked well until liberals (in both parties but mostly Democrats like Obama) discovered that they could buy votes from the parasite class by running up still larger deficits on social programs (i.e. giving out free stuff). So, let's keep the facts straight and not attempt to pass off an imaginary version of history as the truth.

Mark: You make quite a few good points that contradict my belief that monetary policy is accommodative. Bear with me and I'll address most of them.

Whether M2 is up or down by $30 billion or so is a very minor issue. It's very clear however that the growth of M2 has slowed considerably and by some measures is modestly negative. Does this confirm that money is tight? No. In my view M2 is a better measure of money demand than it is of money supply, so very slow growth in M2 is a reflection of very weak money demand.

Commodities are down since April, as you note. Is that a sign of tight money? Not necessarily. The magnitude of the recent decline in commodities is no more than it has been at other times; it could well be just another random correction in an upward trend.

Gold, arguably the premier commodity to watch, is off slightly from its recent all-time high, but is up meaningfully from the end of '09, and is up from April levels.

10-yr T-bond yields are down signficantly from April levels, as you note. Is that a sign of tight money? Not necessarily. In my view 10-yr yields have been a better barometer of the market's view of economic growth prospects than of anything else over the past year or so. The market is obviously in the throes of a big concern over the durability of the global economic recovery, and T-bonds are the safe haven of choice. Should the economy slow as the market fears, that is not necessarily the result of tight money. Indeed, the massively accommodative actions by most central banks have introduced a significant degree of uncertainty to the world's outlook for inflation and growth. Many worry, for example, that a premature withdrawal of excess liquidity could threaten recoveries. It hasn't happened, but it makes people very nervous.

Declining homeowner's equivalent rents accounts for a significant portion of the decline in CPI inflation. To me that appears to be most likely due to the lagged fallout from housing collapse than to tight money.

Mark: It's tough to argue against the wisdom of Milton Friedman, but let me try. I think MF is generally right, but there is a question of causality that he glosses over. Periods of rising inflation are often preceded by low interest rates; indeed, I would argue that inflation can be triggered by a central bank keeping rates lower than it really should. Similarly, periods of low inflation are generally preceded by very high interest rates, precisely because central banks fight an inflation problem by raising interest rates significantly.

Today's low interest rates coincide with low inflation readings, but they are not necessarily predicting that inflation will remain low. Inflation expectations embodied in TIPS prices are modestly lower than they have been over the past decade or so, but TIPS breakeven spreads have not been a terribly reliable forecaster of future inflation. Recall the years of deflation that were (wrongly) predicted by TIPS at the end of '08.

Public Library/Benji: I enjoy discussing history with people whose (usually erroneous) historical knowledge is limited to their own lifetimes.

Public: "Bush was the first to execute preemptive wars and the first to wage war without paying for it."

Let's see, the Revolutionary War, the War of 1812, the Mexican War, the Civil War, the Spanish-American War, the Philippine Insurrection, World War I, Korea and Vietnam were all optional (or "preemptive") wars in which the US fought. Each of these could have been avoided had the leaders at the time so chosen. Moreover, I think it is fair to say that every American war has been financed rather than paid for at the time of the war. The Civil War, for example, saw the advent of modern government bond markets which were used to finance the massive costs of the war for the North. I suggest you read "Fifty Years In Wall Street" by Henry Clews for a more detailed history of this. More recently, World War II saw massive government deficits and debt in order to finance our victory. And of course, LBJ's policy of guns and butter government spending during the Vietnam War ignited inflation. So, let's not pretend that Bush was the first President to fight a preemptive war or the first President to finance a war. Nothing could be further from the truth.

Benji: "Whatever we spend on our military should be paid for, not borrowed."

When has the ever happened for a sustained period? The US has run a deficit for most of its history. But, if you insist on a pay as you go system, reduce or eliminate the entitlements and social spending lavished on your parasitic fellow Obama voters and we could run a surplus forever. National defense is mandatory, national healthcare is optional.

"Milton Friedman advocated the use of a progressive consumption tax to finance military mobilizations. "

And? Is stating this supposed to cause you to prevail in a debate? I'll tell you what though. Let's follow all of Milton Friedman's policy prescriptions then. Ok?

"In general, I contend federal outlays should be balanced by revenues, except in times of depp recession or full-on wars, such as WWII."

I half agree with you. During times of deep recession however, I would argue that the government should maintain a balanced budget AND cut taxes so as not to drain precious resources from the private sector. I would agree to run deficits to finance necessary wars however.